Municipal Bonds Better Than You Think For many years, the municipal bond market has provided investors with the benefit of earning income that is generally exempt from both federal and state income taxes through investments in securities backed by either the full faith and credit of the issuer (by virtue of the issuer’s taxing authority) or other sources of revenue available to the issuer. While several headline topics have raised concerns among municipal bond investors in recent years, our evaluation of current economic and market factors indicates to us that the condition of the municipal bond market may be better than you think.
Municipal Market Factors - A Look Back In 2013, interest rates rose sharply in a short period of time due to comments made by the Fed Chairman early in the year, and the market’s interpretation of those comments, even though there had been no fundamental change in the economy. The chart to the right illustrates the changes in the yield curve of the AAA-rated taxexempt general obligation index 1 that occurred between year-end 2012, January 2014 and February 2014.
2
The charts below illustrate the yield ratio of municipal bonds versus Treasuries. Typically, yields on municipal bonds are lower than those on Treasuries of a similar maturity, reflecting the value of the tax-exemption applicable to municipal bond income. For a significant portion of 2013, municipal yields were higher than those of Treasuries of a similar maturity. This was due in part to the Federal Reserve buying Treasury securities (driving those yields lower) and the absence of a corresponding level of bond purchases in the municipal bond market.
These charts also demonstrate the difference between the 10-year ratio and the 30-year ratio. Late in 2013 and early in 2014, the 10-year ratio began to decline to a more normal level relative to the comparable Treasury, while the 30year ratio remained elevated, in part due to investor concerns about the possibility of rising interest rates and the greater impact that rising rates could have on long-maturity bonds. 1
Independent rating services (such as Standard & Poor’s, Moody’s and Fitch) assign ratings, which generally range from AAA (highest) to D (lowest), to indicate the credit worthiness of the bonds rated. 2 Yield ratio is the proportional relationship between the yields of two financial securities. For more information on the Aquila Group of Funds, please visit www.aquilafunds.com
Early in 2013, prior to the period of rising rates, the difference between the yield on a 10-year bond and a 30-year bond was fairly stable with an additional 105 to 120 basis points in yield available on the long bond. Later in the year, rates began to rise and demand for long bonds declined (resulting in lower prices and higher yields). Because the long end of the yield curve can experience volatility of this magnitude, our investment strategy is to maintain an intermediate average portfolio maturity. More recently, spreads3 have narrowed and the curve has flattened, indicating that the market is becoming more normalized, and that fear is less of a factor in trading activity. Although there is still a pick-up in yield between the 10-year and 30-year bond, it seems to have more to do with the tone of the market and less with fear.
Credit Risk and Quality During 2013, in addition to comments from the Federal Reserve, headlines regarding Detroit, Puerto Rico and public pension liabilities generated concern in the municipal bond market. In spite of those headlines, and as measured by the actual default experience among municipal credits nationally, the health of municipal credits showed signs of improvement. For the 4th consecutive year, the number of issues in the Municipal Market Advisors (MMA) default database has declined. An additional indication of improvement among municipal credits is the narrowing of the budget gap across all 50 states. As the economy has slowly improved, state revenues have increased while steps have been taken to reduce expenditures. Looking back to 2012, over the course of the year, yield spreads of municipal healthcare issuers (a comparatively high-risk sector of the municipal bond market) narrowed, and remained narrow into the 2nd quarter of 2013, indicating that investors in those bonds were not necessarily being adequately compensated for the relative risk of the issues. When the Federal Reserve indicated their intent to taper long Treasury purchases, introducing an element of fear into the market, spreads on healthcare issues widened abruptly. This demonstrates why, based on our investment strategy, we do not make big bets on what we perceive to be higher-risk sectors. We strive to limit portfolio volatility, and the level of volatility associated with significant allocations to such sectors does not suit that strategy.
Municipal Bond Issuance In 2012 more than 40% of new municipal issuance represented refunding activity, as issuers attempted to reduce their interest expense in a low-rate environment. In 2013, as rates began to rise, the percent of total new issuance represented by refunding declined, and by the 4th quarter, represented 20% of total new issuance, or half as much as in 2012. By that time, rates had risen to a level at which refunding no longer provided a financial benefit to the issuer. The result was a reduction in refunding issuance, which lowered the overall supply of municipal bonds. 3
Spread is the difference between yields on differing debt instruments, calculated by deducting the yield of one instrument from another. For more information on the Aquila Group of Funds, please visit www.aquilafunds.com
Municipal Bond Fund Flows Following the financial crisis in late 2008, investors once again began adding money to tax-exempt funds. In the short period of time between late 2010 and early 2011, largely motivated by the inaccurate predictions of an analyst which introduced fear into the market, investors withdrew assets from tax-exempt funds. Near the end of 2011, investors began to add money to tax-exempt funds again, and that trend continued until early 2013 when comments from the Federal Reserve once more introduced fear into the market, and investors again withdrew assets from taxexempt funds. During both periods of inflows, 600 a portion of the newly invested assets likely 400 represented investors searching for yield in a low200 yield environment. Some of those investors may not 0 have been accustomed to the price changes that occur -200 -400 in bond markets, and therefore may not have been -600 long-term municipal investors. -800 -1000
The blue line here represents fund flows to all single -1200 state municipal bond funds over the period. The red -1400 line represents fund flows to long-term single state -1600 funds, the green line represents flows to intermediate single state funds (3 to 10 year average maturity), and All Single State Muni SS Long-Term SS Intermediate SS Short-Term the yellow line represents flows to short-term single state funds (2-5 year average maturity). What you see here is that flows of intermediate and shortterm funds may be less volatile than those of long-term funds over the period. The chart below is an interesting illustration of the divergence between investment opportunity and investor behavior. The blue line indicates the yield on the 30-year AAA tax-exempt general obligation index and the dark blue area indicates tax-exempt fund flows. Remember that as yields rise, bond prices decline, which might be viewed as a buying opportunity. However, in the recent past, periods of rising yields and declining prices correspond to periods when investors have sold bond funds. It appears that investors, potentially motivated by attractive yields, buy bond funds as yields are declining and prices are rising. It appears that they sell, potentially motivated by fear, during periods of rising yields and declining prices. The buy low, sell high adage does not appear to have guided investor behavior recently in the municipal bond fund market.
For more information on the Aquila Group of Funds, please visit www.aquilafunds.com
Interest Rate Risk and Bond Maturity This chart displays Barclays total return data as of December, 2013 for municipal bond indexes of the maturities indicated along the horizontal axis. As of December 31, 2013, the year-to-date total return (in blue) for the 10-year bond index was negative by approximately 2% while the total return for the 20-year bond index was negative by approximately 4.5%. Shorter maturities tend to display less interest rate risk, which is why our investment strategy is focused on the intermediate portion of the yield curve. 2.00% 1.00% 0.00% -1.00% -2.00% -3.00% -4.00% -5.00% -6.00% -7.00% 1 Year 3 Year 5 Year 7 Year 10 Year 15 Year 20 Year Long (1-2) (2-4) (4-6) (6-8) (8-12) (12-17) (17-22) Bond (22+) 1 Month TR
QTD TR
YTD TR
Each of the factors listed below, or several of them collectively, could potentially be indicative of higher interest rates in the future, however currently, none of them are tilted in that direction. GDP growth and inflation are low, unemployment remains high, commodity prices and corporate earnings are moderate or declining, mortgage rates are relatively stable, lending standards are stronger, and international economies are struggling. These weak macroeconomic indicators don’t point to dramatically higher inflation in the near-term. To have inflation, you need to have demand and we don’t see that in the current economy. It appears that the Fed’s stimulus programs didn’t have a significant impact in terms of generating economic growth. GDP Growth
Inflation
Unemployment
Commodity Prices
Corporate Earnings
Mortgage Rates
Lending Standards
International Economies
Interest Rate Risk and Bond Duration A bond’s duration, specifically modified duration, is an indicator of how sensitive a bond’s price is to a change in interest rates. Duration provides investors with another aspect of comparison between bonds with different maturities and coupon rates. Simply stated, for every 1% change in interest rates, positive or negative, the price of a bond will inversely decline or increase by its modified duration. For example, if a bond’s modified duration is 7 years, the value of the bond could be expected to rise 7% for every 1% decline in interest rates, and fall by 7% for every 1% increase in interest rates. Bonds with longer maturities and lower coupons have a longer duration, and therefore generally experience a higher degree of price fluctuation, while bonds with shorter maturities and higher coupons have a shorter duration and generally experience a lesser degree of price fluctuation. We focus on maintaining an intermediate average portfolio maturity as we strive to reduce volatility in the net asset value of our municipal bond funds. For more information on the Aquila Group of Funds, please visit www.aquilafunds.com
Municipal Market - Factors on the Horizon Now we’ll take a step back and consider the overall conditions impacting the current municipal bond market. Year-over-year new issuance has recently been flat to negative, resulting in a shrinking supply of municipal bonds. Meanwhile, investors continue to maintain a significant amount of uninvested cash on the sidelines. While interest rates may move higher, the magnitude and timing of any such move is uncertain. Tax rates may continue to rise. With an increase in tax rates, taxable-equivalent yields also rise. In combination, the factors listed below may impact the availability, market demand and market values of municipal bonds. Year-over-Year Net Issuance Flat to Negative
Shrinking Asset Class
$10 Trillion in Cash on the Sidelines
Higher Interest Rates
Higher Taxes
Taxable Equivalent Yields
Regarding taxable-equivalent yields, the map below indicates that several states currently have taxable-equivalent yields at or near 6 percent. Taxable-equivalent yield is the taxable bond yield that would be equivalent, on an after-tax basis, to a given taxexempt yield, after adjusting for federal and state income taxes, and the Net Investment Income Tax (NIIT), which is a 3.8 percent tax established by the Patient Protection and Affordable Care Act that applies to the lesser of (1) net investment income or (2) a taxpayer’s modified adjusted gross income (MAGI) in excess of an applicable threshold amount.
TEY 6.10% to 5.92%
TEY 5.86% to 5.70%
TEY 5.66% to 5.50%
TEY 5.49% to 5.30%
The map shows the taxable equivalent yield of an assumed three percent tax-exempt municipal bond based on the individual state income tax rates. The tax rates for the highest earners include the 39.6 percent federal income tax, the top individual income tax rate for a given state and the 3.8 percent NIIT surcharge. California has the highest income tax rate for top earners and requires a 6.1 percent taxable-equivalent yield for a three percent tax-exempt yield. In this illustration, 5.3 percent is the lowest taxable-equivalent yield, and is applicable in states with no income tax, including Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming. For more information on the Aquila Group of Funds, please visit www.aquilafunds.com
The Aquila Group of Funds Approach The investment approach we follow in managing municipal bond funds is based on a disciplined style focused on an average intermediate portfolio maturity, in order to manage interest rate sensitivity, and bonds of investment grade quality coupled with our credit research, in order to manage credit risk. Over the history of our funds, intermediate maturity and high-quality bonds have demonstrated a relatively high degree of market liquidity. This has enabled us to maintain portfolio integrity in a wide variety of market environments, in that the sale of individual bond holdings has not changed the intermediate, high-quality characteristics of the portfolio. Disciplined Style Intermediate Maturity – Manage Interest Rate Sensitivity Investment Grade Quality and Credit Research - Manage Credit Risk Portfolio Liquidity Portfolio Integrity
Our Single-State Municipal Bond Funds Aquila Tax-Free Trust of Arizona Aquila Tax-Free Fund of Colorado Hawaiian Tax-Free Trust Aquila Churchill Tax-Free Fund of Kentucky Aquila Tax-Free Trust of Oregon Aquila Narragansett Tax-Free Income Fund (RI) Aquila Tax-Free Fund For Utah
Before you invest in a fund offered by Aquila Group of Funds® carefully read about and consider the investment objectives, risks, charges, expenses, and other information found in the fund prospectus. The prospectus is available from your financial advisor, when you call 800-437-1020, or visit www.aquilafunds.com. Mutual fund investing involves risk; loss of principal is possible. Investments in bonds may decline in value due to rising interest rates, a real or perceived decline in credit quality of the issuer, borrower, counterparty, or collateral, adverse tax or legislative change, court decisions, market or economic conditions. Fund performance could be more volatile than that of funds with greater geographic diversification. For certain investors, some dividends may be subject to federal and state taxes, including the Alternative Minimum Tax. Consult your professional tax adviser. NOT FDIC INSURED | NO BANK GUARANTEE | MAY LOSE VALUE | NOT NCUA INSURED Aquila Distributors, Inc. | 800-437-1020 | www.aquilafunds.com
